Walter’s Theory on Dividend Policy

Walter’s model on dividend policy believes in the relevance concept of a dividend. According to this concept, a dividend decision of the company affects its valuation. The companies paying higher dividends have more value as compared to the companies that pay lower dividends or do not pay at all. Walter’s theory further explains this concept in a mathematical model.

Crux of Walter’s Model

Prof. James E Walter formed a model for share valuation that states that the dividend policy of a company has an effect on its valuation. He categorized two factors that influence the price of the share viz. dividend payout ratio of the company and the relationship between the internal rate of return of the company and the cost of capital.

Relation of Dividend Decision and Value of a Firm

According to Walter’s theory, the dividend payout in relation to (Internal Rate of Return) ‘r’ and (Cost of Capital) ‘k’ will impact the value of the firm in the following ways:

Relationship between r and k Increase in Dividend Payout Decrease in Dividend Payout
r>k Value of the firm decreases Value of the firm increases
r<k Value of the firm increases Value of the firm decreases
r=k No change in the value of the firm No change in the value of the firm

Assumptions of Walter’s Model

Walter’s model is based on the following assumptions:

Internal Financing

All the investments are financed by the firm through retained earnings. No new equity or debt is issued for the same.

Constant IRR and Cost of Capital

The internal rate of return (r) and the cost of capital (k) of the firm are constant. The business risks remain same for all the investment decisions.

Constant EPS and DPS

Beginning earnings and dividends of the firm never change. Though different values of EPS and DPS may be used in the model, but they are assumed to remain constant while determining a value.

100% Retention/ Payout

All the earnings of the company are either reinvested internally or distributed as dividends.

Infinite Life

The company has an infinite or a very long life.

Walters Theory on Dividend DecisionsWalter’s Model Valuation Formula and its Denotations

Walter’s formula to calculate the market price per share (P) is:

P = D/k + {r*(E-D)/k}/k, where

P = market price per share

D = dividend per share

E = earnings per share

r = internal rate of return of the firm

k = cost of capital of the firm

Explanation: The mathematical equation indicates that the market price of the company’s share is the total of the present values of:

  • An infinite flow of dividends, and
  • An infinite flow of gains on investments from retained earnings.

The formula can be used to calculate the price of the share if the values of other variables are available.

A company has an EPS of Rs. 15. The market rate of discount applicable to the company is 12.5%. Retained earnings can be reinvested at IRR of 10%. The company is paying out Rs.5 as a dividend.

Calculate the market price of the share using Walter’s model.

Here,

D = 5, E = 15, k = 12.5%, r = 10%

Market price of the share = P = 5/.125 + {.10 * (15-5)/.125} /.125 = 104

Implications of Walter’s Model

Walter’s model has important implications for firms in various levels of growth as described below:

Growth Firm

Growth firms are characterized by an internal rate of return > cost of the capital i.e. r > k. These firms will have surplus profitable opportunities to invest. Because of this, the firms in growth phase can earn more return for their shareholders in comparison to what the shareholders can earn if they reinvested the dividends. Hence, for growth firms, the optimum payout ratio is 0%.

Normal Firm

Normal firms have an internal rate of return = cost of the capital i.e. r = k. The firms in normal phase will make returns equal to that of a shareholder. Hence, the dividend policy is of no relevance in such a scenario. It will have no influence on the market price of the share. So, there is no optimum payout ratio for firms in the normal phase. Any payout is optimum.

Declining Firm

Declining firms have an internal rate of return < cost of the capital i.e. r < k. Declining firms make returns that are less than what shareholders can make on their investments. So, it is illogical to retain the company’s earnings. In fact, the best scenario to maximize the price of the share is to distribute entire earnings to their shareholders. The optimum dividend payout ratio, in such situations, is 100%.

Criticism of Walter’s Model

Walter’s theory is critiqued for the following unrealistic assumptions in the model:

No External Financing

Walter’s assumption of complete internal financing by the firm through retained earnings is difficult to follow in the real world. The firms do require external financing for new investments.

Constant r and k

It is very rare to find the internal rate of return and the cost of capital to be constant. The business risks will definitely change with more investments which are not reflected in this assumption.

Summary

Though Walter’s theory has some unrealistic assumptions, it follows the concept that the dividend policy of a company has an effect on the market price of its share. It explains the impact in the mathematical terms and finds the value of the share.

References:

Last updated on : June 18th, 2018

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